Friday, 26 September 2008

A heated debate

A suggestion for Barack Obama's team: if John McCain doesn't show up for the debate this evening, why not get Warren Buffett onstage with Obama to explain the crisis and talk through pragmatic solutions for it? I'm sure he can take the evening off from sorting out Goldman Sachs.

Virtually nobody is trusted more by the public on these matters than Buffett, and he's already endorsed and advised Obama during the campaign. It might be pretty good for Obama's image as a safe pair of hands.

Credit crisis latest

From the FT today:

"Towards the end of the week several rivals said they had dropped internal restrictions on approaching Morgan Stanley clients when it became clear how much potential custom was available."

Why on earth do investment banks have "internal restrictions" on approaching each other's clients? I appreciate that they would end up spending lots of time chasing new leads and winning new clients only to lose existing business to the other banks who start poaching their clients. They would probably end up reducing fees and increasing sales budgets without expanding the market much, just pinching share from each other. Maybe not an ideal result for the banks.

But in any other industry that's called a cartel. Why should investment banks be exempt from competition law?

If the public is taking the opportunity to get some reforms in return for its $700bn, this could be one to throw in.

p.s. As usual, Martin Wolf's take on the issue is pretty sound.

Monday, 22 September 2008

New ways of managing risk

We need certainty about the future in order to do anything. It’s a basic requirement of the action-feedback cycle that intelligent beings use to achieve their goals.

On the simplest level, if I want to pick up an apple to eat, I need to know that when I tense my arm muscles, my hand will move in such a way, and when I grip it and pick it up, it will weigh (more or less) how much I expect, so that I need to apply just this much pressure to bring it to my mouth. I need to know that it will be this hard to bite and that it will give me some energy and assuage my hunger. If I am missing any of this information it’s highly unlikely I’ll be able, or even want to try, to pick up and eat the apple.

In a more sophisticated decision I need the same predictability. I have to know that when I hire this person, they’ll show up at work, and when I sign this contract, the customer will pay the money on time, and when I build this car, someone will buy it. If we have certainty, it lets us see clearly how to make our lives better – because we can simply look at the future consequences of each action and determine which one is the best.

However, I can’t get absolute certainty on any of these decisions. The new employee may stop turning up, the customer may go bust or nobody may want the car. I can estimate the probabilities but I can’t make the uncertainty go away. So how do I take the action if I don’t know what the result will be?

To some extent, of course, I can act without complete certainty. If I’m not sure how much the apple will weigh, I can apply extra effort just in case. To mitigate the consequences of my employee not showing up, I can make sure not to book any meetings during her first few days, so I’m available to fill the gap if she isn’t here. These solutions clearly reduce efficiency and waste time or resources. The greater the certainty I can achieve, the more efficiently I can work. Tools for certainty are one of the critical contributors to a successful economic system.

This is one of the three reasons that credit exists (the others are to enable pooling and specialisation, and to transfer resources through time; to be dealt with later). Credit allows me to take actions, without full certainty about the outcomes, because I know that I can at least feed myself in the meantime. It lets the risk of default be pooled in return for an insurance component to the interest rate; it allows us to act as if we have full certainty without incurring the high cost of achieving it. It gives me the breathing space to know that even if something does not go as planned, I’ll have the chance to fix it.

Indeed the availability of credit actually increases the net amount of certainty in the world. Here’s a short example illustrating why. If my risk of default is 10% and so is yours, the risk of either of us defaulting is 19% but the risk of both of us is 1%. When you have 100 people involved, the chance of at least one person defaulting is 99.997%, the chance of at least 10 people defaulting is 57%, but the chance of 100 people defaulting is only 1 in 10100. You can make a highly accurate and certain prediction of your loss, and therefore turn the situation into one of certainty for all 100 participants. (This assumes that the chances of default on each loan are mutually independent – Nicholas Taleb has explained in depth why that’s not always true. One of the mistakes was to package up debts – such as 100 separate subprime mortgages – with a highly correlated risk of default. But the principle works if applied sensibly).

John Gapper writes in this week’s Financial Times that credit derivatives are a zero-sum game, because losses equal profits. But that’s not quite correct. Even though the money that’s transferred under the derivative contract nets to zero, the certainty that the tools provide (if designed correctly) creates non-zero-sum outcomes.

So the growth of credit in the last ten years has enabled people to act as if they have a lot of certainty. Companies have invested hundreds of billions on the basis of future expected returns, because they’ve been able to borrow to finance it. Millions of new services and products have been created out of this investment. Consumers have increased consumption because they ‘know’ that they can pay for it later, and it will bring them more joy to own something now than in the future. Our lives have genuinely become better because of credit.

If there is no more credit in the economy this is going to stop. Of course, there won’t be no credit but there will probably be much less. This takes away one of our major tools to deal with uncertainty. This will reduce the amount of economic activity because people cannot invest or spend without some certainty that they are able to pay for it, and that they will get something back in return.

So what will we do instead to reduce uncertainty and enable people to spend again? There are some alternatives:

  1. Better data and analysis. Storing and using information better, and interpreting it correctly is an excellent way to reduce uncertainty. We have much better IT now than we ever had (and no reason this improvement should stop) so the likelihood is that we will gain certainty in this way.

  2. More transparency. One big reason for lack of certainty is that other people have information that we don’t know. The more open we are about our businesses and our lives, the more accurately and confidently others can make decisions on that basis.

  3. Participation in commitment structures. If we commit ourselves to act in a predictable way and make it credible that we’ll do so, others can make accurate decisions on the basis of our future actions. This is what contracts and laws are for – but we can go beyond the existing structures and make ourselves more reliable still.

  4. Tests and prototypes. By providing ourselves with laboratories – spaces to try things out quickly and test the consequences – we can gain greater certainty about how things will develop.

  5. Raising the status of knowledge and trust in experts. Knowledge is what provides certainty, and a time investment is needed to create knowledge. That time investment will get the best return if it is not duplicated – if we trust in worldwide centres of excellence which have the opportunity to explore aspects of the world (and especially the social sciences) and publish their results so we can all use them.

All this isn't quite a coherent economic strategy. Yet. Give me a little longer...

Wednesday, 17 September 2008

The new new new economy

If the leveraged financial structures supporting the operations of the world economy are unravelling, what will happen?

In the short term, it's dangerous. Today, according to the FT, banks are refusing to lend to each other. Soon that will start to have knock-on effects for exporters, and soon after that for domestic business too. They can't borrow money because their banks' risk models require the loan to be laid off to other parties who will no longer play. So companies won't be able to get export finance, and won't be able to take on domestic projects that require financing either.

Why is that? If the money is out there but the banks won't lend to each other, people who need it are going to have to start finding new financial suppliers. Let's say that bank A has a strength in lending foreign exchange to manufacturers, and usually finances this by swaps with banks B and C in the forex markets. The money is spent by the manufacturers and comes back into the market soon enough where it is recycled. If all manufacturers go to bank A, the specialist, they still have access to the asset pool of all three banks which is enough to lubricate the market (almost by definition - as the amount of trade will grow until it uses the available capital).

But if the interbank market seizes up, bank A will run out of funds to lend - the recycling process leads to B and C having more forex than they can find customers for, but they'll hang onto it just in case. So the manufacturers will be forced to go out looking for funds with B and C - who are not really set up to lend it, and don't understand the market or the risks as well as A. The manufacturers incur more cost in having to find and switch suppliers; banks B and C incur a higher cost of supply than A would; the economy becomes less efficient as a result, and everyone has less time to spend on actually making things. We are making manufacturers do the job of interbank traders, and traders do the job of retail lenders, and we lose the benefits that specialisation brings to the economy.

In reverse, this process is one of the reasons the world economy has been able to grow so strongly over the last eight years. The efficiencies provided by financial specialisation and intermediation have been greater than most people ever anticipated. We're used to the our businesses growing and being more efficient because of 'real economy' technological developments, and sometimes managerial innovation, but we don't really notice that financial structures are a big reason for it too.

These are structures of specialisation, knowledge leverage and abstraction. Specialisation lets the people who are best at something do it, so that more output is generated by the whole system (comparative advantage). Knowledge leverage means that the investment in developing one set of knowledge (e.g. how to deal efficiently with manufacturers requiring import finance) is spread over the maximum number of customers, reducing the number of people who have to learn it and allowing that learning time to be used for something else productive. Abstraction means that we can deal with a concept that's close to us and ignore the myriad complex things behind it. We are therefore able to spend less time thinking, and think more accurately when we do. An important special case of abstraction is being able to make decisions based on the present which will affect us in the future. The ability to 'shift time' in this way is a crucial aspect of economic effectiveness.

These three factors are the causes of economic growth. They are expressed in thousands of different ways, and in recent years (since the technology boom of the late 90s calmed down) financial market structures have been the dominant generators of these factors.

So if the finance markets stop working, the growth of the real economy could potentially be hurt badly.

Now it won't be as dreadful as some people think. Whatever the levels of real economic output and consumption that were happening before the markets stopped, people know what those levels were. Consumers expect to buy a certain amount of stuff, manufacturers know how to make that amount of stuff, and there is a shared belief that this is a sensible amount of stuff to trade. And people are pretty smart. So they will find a way to make, market, transport, sell and buy the same amount of things as they ever did.

But without the coordination of the finance markets, they'll have to find another way to do it. Another way to look at those markets is transmitters of (relatively) reliable information. They can tell a Chinese manufacturer what the demand is for their output (through the prices in the Chinese economy and the exchange rate between the yuan and dollar); they can tell the Saudi government how much to invest in new oil terminals (through the price of a futures contract in the oil market); and the more complex and liquid the markets get, the more detailed and accurate (and harder to deliberately manipulate) the information becomes, if you know how to read it.

So the financial markets act as a giant computer, factoring in the information about demand and supply, and risk, and the past and future, and coming up with the answer: here is the best way to allocate your resources, world - this will get you the results you want.

And if the computer has crashed, but we still want to get the same allocation? We had better come up with some new methods.

There seems little doubt that GDP will slow or shrink for a little while, as people adjust to having to send their allocation signals in a new way. But there are other ways to do that. Before there were complex financial markets, it used to happen (much more slowly) through conventional trading and the interactions of the markets for real products. In some societies it was done through central coordination. In others, cultural trends emerged (the blacksmith's son became a blacksmith and the farmer passed his land to his children) which provided a reasonably effective allocation of resources.

Personally I think the new coordination mechanism in the economy - the new structures that will ensure specialisation, knowledge leverage and abstraction - the new way for us to communicate resource allocations to each other - will be by designing mathematical economic structures and learning to trust them.

After the Internet and telecoms bubble that accompanied the new economy of the 90s, after the finance and derivatives boom that came with the new new economy of the 00s, the new new new economy - that will dominate the 2010s - is based on this. The people will take back their understanding of economics from the Internet geeks and the investment bank gamblers; people who work in businesses will be, democratically and self-interestedly, in charge of the abstract structures that govern them.

And there will be another wave of growth, and we'll look back on this as a quaint, backwards decade, like every decade does, and we'll all be a third richer in ten years than we are now, just like we are a third richer than ten years ago. And then, maybe there will be another pause when the new structures have run their course - but I'm not ready yet to predict what will come after that.

Tuesday, 9 September 2008

Client value management, customer value management and what is value?

I have been researching the concept of client value management (also known as customer value management). The idea has been around for a while, and is mentioned by lots of people as an evolution of CRM (customer relationship management). A number of marketing experts and consultancies discuss it as a business process but surprisingly it does not seem to be an established software category and few of the approaches have been implemented in software.

Everyone has their own version of what CVM means. Some of the main distinct approaches are:
  • maximising the value of a client over the lifetime of your relationship with them (this report by BusinessObjects, and some research it cites from Bain and Company). This is approached by analysing value during acquisition, relationship management and retention.
  • understanding customer value added and targeting your marketing and customer service improvements to where they achieve maximum benefit (a consultancy called CVM from New Zealand)
  • finding out what your customers are looking for in dealing with vendors (what they value) and how well you're meeting those needs (according to CVM Inc and Ray Kordupleski - who has some interesting graphical tools on that website and has written a book about CVM)
  • building a business which delivers what the customer wants (from a report by The Networking Firm)
  • analysing your value proposition and market positioning relative to your competitors. This book from the American Productivity and Quality Center outlines an approach to achieving that.
  • An approach which seems to be purely focused on accounts receivable and cash collection
Apart from these, you can find a number of other people and companies with their own spin on some of these ideas. These include Accenture which is partnering with BusinessObjects (though their definition is "developing business and operational processes that maximize the value that customers receive" - not really compatible with BusinessObjects' version), Capgemini, Diamond Cluster which has published a few articles on the subject, EuroPraxis which has an approach called ACM linked to the idea of customer attention, Customer Value Inc which works on value-based pricing, Unity Solutions (Richard Neale) who focus on customer profitability and Teleperformance which uses "the CVM economic model developed in collaboration with Professor Robert Blattberg".

Well, that sounded intriguing so I went to look further. Along the way I found another professor, Nirmalya Kumar of London Business School, who has been interviewed on the subject and written a book, Value Merchants. Which turns out to be coauthored by James Anderson, a colleague of Blattberg's at the Kellogg School of Management. Next, a research project at the University of Southampton which investigates customer value using data from a large insurance company and is carried out by Dr L Thomas and Dr S Thomas, neither of whom unfortunately seems to be the same person as Jacquelyn S. Thomas, who has coauthored a different book with Blattberg. Either way, it seems like this guy is getting around a bit.

Searching again for his name, I found this very useful paper by Adrian Payne and Sue Holt which cites him. From 1999, but still relevant. Its introduction summarises nicely the dilemma I'm having in examining all the sources mentioned above.

The main distinction between the different approaches is the definition of value. That's quite well illustrated by this report, by a consultancy called Deep Insight. It starts out saying 'value is in the eyes of the customer'; moves onto 'lifetime value of the customer' which is the total financial return on that customer from the supplier's point of view; and then segues into the value of the customer relationship from the employee's viewpoint. It's an interesting report but hard to keep track of what the meaning of 'value' is.

Blattberg seems to be firmly on one side of this debate: value is what the customer is worth to the organisation. His customer equity concept is a way to model and measure this, and the relevant parts of his work are about maximising this value and investing in the customers with the highest equity.

OK, but I say the customer's value to the firm will be served best by increasing the firm's value to the customer. To achieve this you need to understand what the firm's value to the customer is. Here's my proposal.

  1. Understand what the client values in general, in their life. What are the basic psychological and physical needs that they have? Typically there are two soft needs (avoiding pain and stress, maximising pleasure and success) and two material needs (money and time). These are value factors.
  2. Work out (or ask) how the client achieves those needs. They are influenced in such a complex and detailed manner by decisions in life, that it is impossible for anyone to genuinely make all their day-to-day decisions in terms of those four basic factors. Therefore, people choose proxies or value objects. These are the things that people pursue in life because, subconsciously, they know that they will satisfy the four basic factors. They could be anything from nice food, to high status in their community, to winning new clients, to saving tax.
  3. Work out how your services can generate these value objects. If you're an accountant, your service of setting up a pension is valued because it helps your customer save tax. If you're an advertising agency, your service of designing a TV ad is valued because it helps your customer win more clients.
  4. Offer and promote the services which generate the highest underlying value - the greatest amount of the four value factors - for your clients. These will be the most profitable services for you to offer and will make your clients happiest.

Friday, 5 September 2008

Structured pricing in the property market

Pricing, fundamentally, is a way of transferring a fair share of value from buyer to seller in return for the service the buyer receives.

However, it is sometimes challenging to measure the value that each party obtains in a transaction. Also, economic theory contains a concept called asymmetric information which means that either the buyer or seller has information that the other does not. This is often as simple as “how much do I really want this” but it may be that one party actually knows something concrete that the other doesn’t, and can take advantage.

For these reasons, in the early stages of development of a market, simplified pricing models arise. These act as proxies for the real value of the transaction – making it easier for people to negotiate. In the property sector, the typical proxies are fees based on a percentage of sale or rental price. In professional services, the typical proxy is a fee per hour which may vary according to the experience of the individual being employed.

The reason these proxies exist is to make it simple for unsophisticated buyers or sellers to do business with each other. However, they have a huge drawback: they prevent viable economic transactions from taking place. By viable I mean transactions which would benefit both parties, and which we would naturally wish to happen – a new service would be provided for a buyer, and a seller would receive money in return. This is because the pricing models are too simplistic to capture the extra value provided by these additional services, and so there is no room for the seller to be creative in finding new solutions to the buyer’s needs.

As markets become more sophisticated and mature, economic activity will stagnate if new models are not found. Buyers and sellers learn more about the marketplace, and become capable of negotiating and measuring better models which provide more value to both parties. The old models become outdated and start to show the strains – which we’re seeing in the market now, and which the Carsberg report endorses.

Structured pricing is the solution to this.

Structured pricing means that the price of a service is based on the value generated by the service, and not on a simplified percentage-based model. The user of a service gets value in many ways which are not reflected in a percentage-based fee.

For example:
  1. A buyer may find the home of their dreams – bringing a degree of happiness far beyond the satisfaction of getting the house a few thousand pounds cheaper.
  2. A vendor may have a fast and hassle-free completion, saving them weeks or months of worry and stress
  3. A landlord may let their property to tenants they trust, who they know will take good care of it and pay their rent on time – removing the worry that rent may not cover mortgage payments or that the fabric of their house will be destroyed
  4. A commercial tenant may gain the reassurance that their property will meet the functional and productive needs of their staff, and any problems will be fixed promptly – helping them feel like a more professional business as well as saving money on facilities management
These benefits are what people really want when they buy, sell or let property. So why stick with a pricing model that actively discourages these goals from being successfully achieved?

Structured pricing analyses the values of each party in a transaction, and puts a price on each of them. This encourages everyone involved to find the best way to meet each other’s needs and can transform the experience and the success of a negotiation.